What Is Yield Farming in Cryptocurrencies

Dec 30, 2021 03:29 PM ET
What Is Yield Farming in Cryptocurrencies

Cryptocurrency holders have the option of keeping their assets idle in a wallet or locking them in a smart contract to help with liquidity. The liquidity created in this way might be utilized to power token swaps on decentralized exchanges like Uniswap or to make borrowing and lending easier on platforms like Aave. In the field of decentralized finance, yield farming is one of the trendiest topics.

What is yield farming?

It is a method that entails generating interest in your cryptocurrency in the same way that you would collect interest on any other type of money in your savings account. Yield farming is staking your cryptocurrency for a period of time in exchange for interest or other benefits, such as more cryptocurrency.

The amount given out is paid back with interest when traditional loans are issued through banks. The concept is the same with yield farming: a cryptocurrency that would otherwise be sitting in an account is instead loaned out to earn rewards.

How does it work?

Yield farming allows an investor to stake their coins by putting them into a lending protocol via a decentralized app (dApp). Other investors may then borrow the coins through the dApp to use for speculation, hoping to benefit from big fluctuations in the coin's market price that they foresee.

Yield farming is nothing more than a reward system for early adopters. Users are rewarded for staking their currencies in blockchain-based apps, which allows them to provide liquidity. When centralized crypto platforms collect consumer deposits and lend them out to individuals seeking credit, this is known as staking. Creditors pay interest, depositors receive a portion of it, and the bank keeps the remainder.

Smart contracts, which are simply a piece of code running on a blockchain and acting as a liquidity pool, are frequently used.  By putting their money inside a smart contract, users may lend it to others. Investors that use the yield-farming technique to lock up their coins may earn interest and frequently additional digital coins, which is the actual benefit of the transaction. If the value of those additional coins rises, so make the investor's profits. This procedure offers the liquidity that freshly released blockchain apps require to continue to expand over time. 

By compensating users with incentives like their own governance tokens or app transaction fees, these apps may enhance community involvement and secure liquidity. Yield farming might be compared to the early days of ride-sharing. Due to the necessity to bootstrap growth, Uber and other ride-sharing apps offered incentives to early customers who recommended others to the platform.

Another reason to stake is to collect enough cryptocurrency to cause a hard fork. A hard fork is a change in the protocol of a cryptocurrency network that causes blocks or transactions to be verified or invalidated, requiring developers to update their protocol software. Hard forks allow cryptocurrency holders to compel modifications that will benefit the cryptocurrency in the future. In some ways, hard forking provides crypto investors the same authority that shareholders have with share voting.

Cryptocurrency holders can utilize hard forks to push a cryptocurrency protocol in a certain direction, similar to how shareholders can vote on crucial items influencing the management or direction of the firms they invest in. Staking coins to trigger a hard fork allows crypto to adopt this crucial feature of equity investments, transforming it from a cash-like investment to a quasi-equity investment.

How can you calculate yield farming returns?

Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are two often used measures. The difference between them is that APR does not take compounding into account, but APY does. In this context, compounding refers to the act of reinvesting gains to produce higher returns.

It's also important to remember that these are only estimates and forecasts. Even short-term gains are difficult to predict precisely. Because it is a highly competitive and fast-paced business with quickly fluctuating rewards. If a yield farming approach works for a time, a lot of farmers will take advantage of it, and it will eventually stop producing high returns.

What are the risks involved?

Risk of impermanent loss

This danger exists because automated market makers do not adjust token prices in response to market movements. For example, if the price of asset declines by 80% on a regulated market, the change will not be instantly reflected on a dApp.

Risks associated with smart contracts

Smart contracts are paperless digital codes that contain predetermined rules and self-execute the agreement between parties. Smart contracts eliminate the need for middlemen, making transactions cheaper and safer. They are, nevertheless, vulnerable to attack vectors and coding flaws.

Risks of liquidation

dApps platforms, like traditional finance, employ their clients' deposits to create liquidity to their markets. However, if the value of the collateral falls below the loan's price, a problem may occur.

Capital intensive

This is a bigger problem for smaller participants than for affluent people who have more money. Due to high gas costs, smaller participants may discover that they are unable to withdraw their money.

Examples of yield farming platforms

Compound Finance

It's an algorithmic money market where anyone may lend and borrow money. Anyone with an Ethereum wallet may contribute assets to Compound's liquidity pool and start earning rewards straight away. Based on supply and demand, the rates are modified algorithmically.

Uniswap

It enables token swaps that are trustless. To form a market, liquidity providers deposit the equivalent of two tokens. The liquidity pool can then be traded against by traders. Liquidity providers get fees from trades that take place in their pool in exchange for providing liquidity.

Conclusion

Yield farming is a method of earning money from digital assets through holding cryptocurrency and reaping the benefits. The rewards are calculated annually. The process has risks, and one should know them before diving into the process; for example, it is capital very capital intensive, and one may make a loss instead of profits. Yield farming has expanded over the years, and there are many platforms that offer this service. 


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